Investor confidence tested as Russia invades Ukraine
The risks of higher inflation, and slower growth, have gone up. So too have the number, and the degree, of uncertainties around the possible investment implications of the conflict.
Investors began this year focused on the global monetary policy outlook as inflation continued to march higher. Central banks are still a dominant theme in financial markets, but investors must now also contend with many uncertainties resulting from Russia’s invasion of Ukraine.
Could the war inflict wider economic damage?
There are four main channels through which the conflict may impact on the global economy in coming months.
- Global demand. Tough sanctions and the collapse in the rouble are likely to induce a deep recession in Russia. And Ukraine’s economy will suffer as a direct result of the invasion. This will have knock-on implications for demand elsewhere, especially in Europe. But the impact outside Russia and Ukraine may be limited. Global demand could be hit with a confidence shock, curtailing consumer and business spending. A further squeeze on real incomes from higher energy prices, which we discuss below, could hurt consumer sentiment. But the broader context is healthy: the latest business confidence data, collected before the Russian invasion, was pretty reassuring as post-Omicron reopening is gathering pace, while fourth-quarter corporate earnings have also been strong.
- Financial contagion. Sanctions seem to have dealt a serious blow to Russia’s banks, with customers queuing to remove their cash. Fortunately, US banks have minimal direct exposure to Russia. Some smaller European banks have more, but it’s still limited. On balance, it doesn’t seem like retaliatory sanctions will pose a systemic risk to the wider banking system.
- Energy supply. Russia is a key global energy producer, accounting for 12% of global oil output and 17% of natural gas output. Europe is extremely reliant on Russian energy and could not easily replace it quickly. (EU countries import around 60% of their energy, and Russia is the single largest provider of oil, coal and gas. Without Russian supply, the EU could run out of gas in an estimated six weeks.) Past geopolitical crises which have hit global energy supply hard (the 1973 Yom Kippur War/OPEC embargo, the 1979 Iranian revolution and Iraq’s invasion of Kuwait in 1990) have contributed to recessions and higher inflation across major economies. So far, energy exports have continued despite the conflict and sanctions, with Russian gas still flowing to Europe. We can’t entirely rule out Russia deliberately cutting its energy exports if the conflict escalates further. An energy shock is a key ‘tail risk’ (one with a low probability, but the potential for a very significant negative impact). It would further fuel inflation at a time when many central banks are already sounding the alarm about the risk of higher prices becoming entrenched. Some are talking about aggressive interest rate hikes. This is not our base case, but it is a rising risk and an energy price shock that coincided with a forceful central bank pivot focused on inflation could further dampen investor risk appetite and the outlook for GDP growth.
- Supply of other commodities. Ukraine accounts for 13% of global corn exports and 12% of wheat exports. There are reports of shipments being disrupted, and prices have jumped to multi-year highs, which will contribute to inflationary pressure around the world. Meanwhile, Russia is a major supplier of industrial metals, most notably aluminium, nickel, platinum and palladium. While the sanctions imposed on Russia’s banks include exemptions for energy trading, that’s not the case for metals. As a result, significant supply disruption is possible, again with inflationary consequences globally (albeit not to the same extent as an energy price shock).
It’s uncertain whether the risk of slowing global growth will act as a brake on central bank plans to raise interest rates or whether rising inflationary pressures could prompt more policy tightening than previously anticipated. We believe there are significant risks (and greater dangers of a policy mistake) in both directions.
There is huge uncertainty about the outlook and some of the factors we’ve outlined here are extremely hard to quantify in a meaningful way. On balance, the greatest risks appear to be to the global supply of key commodities (more so than to demand). With that in mind, we believe Russia’s invasion has increased the risks of inflation breaking higher and global economic growth dropping lower.
How we can protect your investments
Some reduction in overall portfolio risk, particularly from overseas equities and emerging market debt, makes sense to us. As does increasing allocations to safer assets, such as gold and cash. Within equity markets, again, uncertainty is the key word. As such, we believe it makes sense to avoid taking active, tactical positions in any style or geography and instead to stick to long-term, strategic allocations.
Even before the conflict, we felt it made sense to avoid significant biases towards overvalued ‘growth’ stocks, as rising interest rates could make earnings received further out in the future less valuable today, and to steer clear of stocks that score poorly on measures of earnings quality. The rationale for that course is even stronger now than it was then.
We believe that growth companies with high-quality and highly profitable business models should continue to be a part of our investment strategies, but that exposure should be balanced.